Portfolio Adviser • October 2016 • Asset Allocator

A good macro view is core to how the fund research team at EFG approaches asset allocation, but its views are based on fundamentals

The research teams at EFG Asset Management are divided into two parts: long-only funds and alternatives. The long-only team sits alongside the macro and asset allocation team as part of the broader research function. “We are not picking funds in a vacuum,” explains Andrew Harradine, head of long-only fund research.

“We are pretty well integrated, we have a weekly team call and a very good awareness of what our hedge fund colleagues are doing. Macro is definitely front and centre to how we approach investing and fund selection.”

At present, EFG’s headline asset allocation is a slight overweight to equities and an underweight to sovereign bonds. An example of how the macro informs the firm’s allocations can be seen in its weighting to emerging markets, which it moved to an overweight position in early 2016.

“Some of the big headwinds facing markets last year were dollar strength and energy and commodity price weakness, both of which were particularly felt in emerging markets,” says Harradine.

“This year, however, the stabilisation and rebound in commodities has fed into the stronger performance of emerging markets.

“We had an emphasis on Latin America within that allocation because we felt that valuations were at rock bottom at the beginning of the year and, politically, things were moving in the right direction. It has been one of our calls for the year.”

Broadly, EFG uses the Schroder QEP Emerging Market Fund, which Harradine describes as a “one-stop-shop” product for global emerging markets exposure. It is an all-cap fund combining quantitative and qualitative elements. For its Latin American exposure, it has selected the Morgan Stanley Latin America Fund, while in the Asean region it uses the JP Morgan vehicle.

EFG is also currently overweight the US, a position that, according to Harradine, has been supported by some recent strong data.

Not only has wage growth been ticking up, but the Federal Reserve continues to behave in a dovish fashion.

US exposure is via a combination of passive and active funds, moving between the two depending on market conditions. But, as Harradine notes, “it has also had a decent exposure to value stocks in 2016, primarily through T Rowe US Large Cap Value”.

Through the Morgan Stanley US Advantage Fund, EFG has increased its exposure to growth stocks in order to take advantage of the opportunities it is witnessing following the sharp sell-off during recent months.

“The fund is a combination of high growth and more defensive names, so it is not an outand- out high-beta high-growth fund. If you look at the free cashflow yield of some of the companies in the portfolios, it is starting to look interesting.”

At the other end of the spectrum, says Harradine, Japan has not performed as well as he hoped. EFG remains overweight the sector, despite Japanese funds having struggled this year, due in part to a strong yen.

Harradine says: “It is clear that valuations look pretty attractive right now. We buy into some of the supply side reforms we are seeing. Not only is there much more emphasis on corporate governance but there has been a significant increase in dividend payouts from Japanese corporates. However, it has been a particularly tricky market for active managers over the past couple of years.”

EFG does not expect the yen to strengthen much from current levels, as it is looking rather overbought, but Harradine predicts some changes occurring at a sectoral level.

He says: “One of the features of Japan over the past few years has been the standout outperformance of defensives; consumer staples, pharmaceuticals, telecoms have dra-matically outperformed the broader market, while financials have been incredibly weak.

“One of the reasons for that has been the global decline in bond yields. Within that there have been some sharp declines in Japanese government bond yields. As a result, the hunt for yield in Japan has intensified and you have seen significant outperformance from those quality income stocks.”

EFG uses Coupland Cardiff Japan Income and Growth to play this dynamic, which Harradine explains is one of the few funds in the sector that is focused on income. He is paying close attention to those companies’ valuations as they are starting to reach “nosebleed” levels.

“Japanese bond yields shot up on the back of the latest Bank of Japan stimulus package and, while it slightly disappointed markets, the move in Japanese government bonds has some pretty profound implications for dividend- yield-oriented stocks.

“We have already seen a bit of underperformance in the space and the key question now is whether this an inflection point.”

If Japanese government bond yields continue to rise, it is likely that value funds, which have underperformed on a relative basis, could come back into play.

“We have taken a bit of a barbell approach in Japan, with a skew to quality income, but we have been taking some profits in the past few months and topping up a bit on the value side. A fund like GLG Japan would, for example, stand to benefit.”

In the UK, EFG’s focus since the referendum vote to leave the European Union is exposure to the FTSE 100 over 250.

“Given the overseas earners in the FTSE 100, we are happy to have some exposure there,” says Harradine. “But the FTSE 250, which is more domestically oriented is a part of the market we do not want to have meaningful exposure to right now.”

The Jupiter UK Special Situations Fund, managed by Ben Whitmore, as well as the Majedie UK Equity Fund provides EFG’s FTSE 100 exposure. However, EFG moved underweight the region overall after the UK’s decision to leave the EU.

The other change triggered by Brexit was its views on UK commercial property, says Harradine: “Back in January, we were getting messages from the property managers that they were raising cash and de-risking portfolios due to the risk of Brexit. That was a clear indication there might be some issues in that space should Brexit come to pass.”

Concerned about valuations, EFG removed its preferred real estate fund from its best ideas list 12 months ago, and began to reduce its exposure after conversations with managers.

“Quite frankly, Brexit happened at the worst possible time for commercial property because so much money had gone into it. We had seriously begun to cut our positions to that space in the first quarter and, as things started to unravel post Brexit, we continued to sell down our positions ahead of a lot of the funds gating.”

EFG also chose to keep its dollar exposure unhedged. From here, Harradine says, he expects further easing and believes that having dollar exposure will continue to be a good source of returns.

The firm also built a structured product that houses a collection of currency managers. “Given the volatility we have seen in currencies over the past few years, the scope for alpha generation there is very high.

“We also like the fact the structured note is uncorrelated with equity markets and has proved a good hedge when equities weaken,” he says.

Within fixed income, EFG is underweight sovereign bonds but overweight credit, though it has taken selective profits in that area. “At the beginning of the year US high yield was a controversial asset class, with concerns about default rates shooting up on the back of weak oil prices.

“But we felt you were being compensated for those risks, so we have been overweight US high yield in 2016.”

EFG has its core exposure to emerging market debt through the Lazard Emerging Markets Debt Blend Fund.

On the more esoteric side of the credit market, the firm has exposure to the capital securities market through the Pimco Capital Securities Fund.

While Harradine acknowledges the risks of bank debt and the capital securities markets generally, the broader challenge is declining sovereign yields.

“It is becoming increasingly difficult to find a decent yielding product and just reaching for yield can lead to a massive increase in the risk profile of your portfolio,” he says. “Selectively having an exposure to financials is one of the areas where we are finding value.”

The other area in which EFG is seeing value is in protection. “The collapse in volatility has been significant so it is pretty cheap to hedge exposure at the moment,” he says.

“Despite having a directionally positive view on equities generally and in the US, we feel we have an opportunity for a cheap hedging exposure and so have taken out some S&P put options.”

‘THE HUNT FOR YIELD IN JAPAN HAS INTENSIFIED AND YOU HAVE SEEN SIGNIFICANT OUTPERFORMANCE FROM QUALITY INCOME STOCKS’

‘BREXIT HAPPENED AT THE WORST POSSIBLE TIME FOR COMMERCIAL PROPERTY BECAUSE SO MUCH MONEY HAD GONE INTO IT’

. EFG’s key asset allocation is overweight equities, underweight sovereign bonds.

. Exposure to emerging markets and Latin America in particular has been the firm’s call of the year.

. EFG remains overweight Japanese equities, despite poor performance from the asset class year to date, and sees value in cheap inflation protection.